Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Parker-Hannifin Corporation (NYSE:PH) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Parker-Hannifin's Debt?
You can click the graphic below for the historical numbers, but it shows that Parker-Hannifin had US$6.62b of debt in March 2021, down from US$9.13b, one year before. However, it does have US$529.9m in cash offsetting this, leading to net debt of about US$6.09b.
How Healthy Is Parker-Hannifin's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Parker-Hannifin had liabilities of US$3.04b due within 12 months and liabilities of US$9.40b due beyond that. Offsetting these obligations, it had cash of US$529.9m as well as receivables valued at US$2.46b due within 12 months. So its liabilities total US$9.45b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Parker-Hannifin is worth a massive US$40.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Parker-Hannifin's net debt of 2.2 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.4 times interest expense) certainly does not do anything to dispel this impression. Parker-Hannifin grew its EBIT by 4.9% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Parker-Hannifin can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Parker-Hannifin generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
The good news is that Parker-Hannifin's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its interest cover was a positive. Taking all this data into account, it seems to us that Parker-Hannifin takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Parker-Hannifin .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
When trading Parker-Hannifin or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.